This issue also arises unto the Japanese tax system. However, tax reform in 2006 introduced a rule that specifically addresses this concern (below the ‘Distribution Allocation Rule’ or ‘DAR’).
One impact of the DAR is to limit the discretion of directors or shareholders of a Japanese company to characterize a distribution as either income or return of capital through, for example, the directors explicitly referencing the source of the distribution in the shareholders resolution approving the distribution concerned.
Different definitions under corporate and tax law
In order to understand how the DAR operates it is important to be clear about whether reference is being made to items defined under the Japanese Corporate Law (below the ‘JCL)’ or instead terms defined under and Japanese tax law. Confusingly the terms used in the JCL and in the tax law for items in a company’s capital account sound very similar in Japanese and inconsistent translation into English add to this confusion.
Before addressing the DAR it is helpful to review the terms involved.
Distributions out of income or capital under the JCL
Please see this article for a more detailed description of items that make up a Japanese company’s capital account under the JCL.
A Japanese company will determine its overall surplus available for distribution to shareholders under the JCL. The company can then resolve at a shareholder’s meeting to make a distribution within the limit of this surplus out of either Capital Surplus (in Japanese ‘資本剰余金’ or ‘shihon jyouyo kin’ ) or out of its Profit Surplus (in Japanese ‘利益剰余金’ or ‘rieki jyouyo kin’).
Income or capital for Japanese tax purposes
Capital Surplus and Capital Surplus are both Japanese Corporate Law concepts. Japanese tax law defines items that correspond conceptually to these.
Follow the link to this article for an explanation of the first of these tax law items, ‘Tax Based Capital’ (in Japanese ‘資本金等’ or ‘shihonkin tou’) which is the tax equivalent of the JCL defined Capital Surplus (as well as encompassing other JCL capital items).
This article explains in more detail the second Japanese tax law concept of ‘Tax Based Retained Profits’ (in Japanese ‘利益積立金’ or ‘rieki tsumitate kin’), which is similar to the US tax concept of Earnings and Profit and corresponds conceptually to the JCL concept of Profit Surplus.
Taxation in the hands of the shareholder
Where a distribution is treated by the tax law as being made out of Tax Based Capital it will, unsurprisingly, generally be taxed in the hands of the shareholder as a return of capital.
A foreign corporate shareholder receiving such a distribution would generally have to calculate their overall capital gain or loss for Japanese tax purposes, including any appropriate deduction for the original cost of the part disposal of the shares concerned.
The company may then pay Japanese corporate income tax on its net profit, unless the capital gains clause of any applicable tax treaty can exempt such tax. Japanese withholding tax would not apply to such a distribution.
A distribution treated by the tax law as being made out of Tax Based Retained Earnings will generally be taxed as a dividend in the hands of the shareholder (in Japanese taxed as a ‘受取配当’ or ‘uketori haitou’, below ‘Dividend Received’).
For a Japanese corporate shareholder the dividend received deduction would apply. Japanese withholding tax at 20 percent rate for unlisted shares would also typically apply unless the rate is reduced under the dividends article of an applicable tax treaty.
Interaction between corporate and tax law
When making a distribution under the JCL the relevant shareholder resolution may refer to the source of the distribution as defined in the JCL (e.g. whether made out of Capital Surplus or Profit Surplus). The tax law, including the DAR, is then applied to decide how this JCL defined distribution is characterized for Japanese tax purposes.
Where a distribution is made wholly out of Profit Surplus as defined for JCL purposes, the amount is also treated as being paid out of Tax Based Retained Earnings for Japanese tax purposes ( CTL 23-1-1, ITL 24-1) and taxed as a Dividend Received as described above.
In contrast, where a distribution is made out of Capital Surplus under the JCL then the amount maybe treated for tax purposes as a mix of both Tax Based Capital (taxed as a capital gain for the shareholder), and of Tax Based Retained Earnings (taxed as a deemed Dividend Received in the hands of the shareholder). The characterization applied for tax purposes in fact will depend on the ratio of Tax Based Capital to Tax Based Retained Earnings measured at the time the distribution is made.
Application of the DAR
The DAR applies when a distribution is made out of both Capital Surplus and Profit Surplus.
The DAR rule is quite logical. The amount of reduction in Capital Surplus resulting from the distribution is first found under the JCL. For tax purposes the amount of Tax Based Capital is then treated as being reduced by this same amount. Any amounts exceeding this reduction in Tax Based Capital is then treated as being a distribution of Tax Based Retained Earnings. Taxation in the hands on the shareholders will then be either as capital gain or as a Dividend Received respectively following the same principles above (CTL 24(1) CTLEO 8(1)-19).
Relationship to distributions resolved by shareholders
The objective of the DAR is to prevent the tax characterization of a distribution from depending only on the decision of the company in a shareholders’ meeting.
For example, a shareholders’ resolution which first determined an amount of distribution be paid out of Profit Surplus which was then followed by a resolution to reduce Capital Surplus may not necessarily be effective if intended to treat the whole of the first distribution as being made out of Tax Based Retained Earnings.
Instead the second resolution may be taken into account under the DAR and only the excess over in the distribution treated as being made out of Capital Surplus treated as a distribution of Tax Based Retained Earnings.
Points to watch
Given the above it is important that a company knows the amounts of Capital Surplus and Profit Surplus that make up its JCL defined capital account.
However a company should also work out the amounts of its Tax Based Capital and Tax Based Retained Earnings (these figures may be found on the tax return) and then take care about how its distribution is resolved and how the related rules apply if it wishes to assess the Japanese tax impact of a distribution to its shareholders.